1. INTRODUCTION
In a recent decision, the United States Court of Appeals for the First Circuit (the First Circuit) reversed a lower bankruptcy court decision that absolved a university of fraudulent transfer liability stemming from tuition payments received from a student’s parents.[1] The parents, who pled guilty to orchestrating a Ponzi scheme, were presumed to be insolvent at the time the tuition payments were made.[2] The issue of whether colleges and universities may be sued by bankruptcy trustees to recover tuition payments made by insolvent parents for the benefit of their adult children has divided bankruptcy courts for years. In re Palladino, 942 F. 3d 55 (1st Cir. 2019), marks the first appellate-level decision to address the issue.
From an objective bankruptcy law perspective, the Palladino case was rightly decided by the First Circuit. Indeed, a fundamental goal of bankruptcy is to ensure that similarly situated creditors are treated alike and share equitably in the distribution of debtor assets. To achieve this goal, title 11 of the United States Code (the Bankruptcy Code) grants a bankruptcy trustee (or debtor-in-possession) several important powers. Chief among the trustee’s powers is the ability to “avoid”[4] transfers and/or transactions as set forth in sections 544 through 549 of the Bankruptcy Code. This article will consider issues prevalent in bankruptcy avoidance actions. However, the central focus of the article is on the intersection between the exercise of avoidance powers against colleges and universities and public policy encouraging parental contributions to higher education.
2. TRUSTEE STRONGARM POWERS AND AVOIDANCE ACTIONS IN BANKRUPTCY
Under state fraudulent transfer statutes,[5] a creditor may seek to avoid a transfer made by a debtor to a third party if under the circumstances, the transfer was adverse to such creditor.[6] In avoiding such transfers, applicable state law allows the creditor to “reach-back” to recover payments made as many as six years prior the bankruptcy filing. The Bankruptcy Code in turn allows trustees standing to pursue such transfers under state law “in the shoes” of the harmed creditor. In addition, the Bankruptcy Code provides the trustee with direct substantive avoidance powers, albeit with a reach-back period generally limited to two years.[7]
The Bankruptcy Code empowers bankruptcy trustees to avoid and recover fraudulent transfers, including those attributed to constructive fraud, from the recipient (in this context, the university). As noted by the United States Supreme Court in Central Bank of Washington v. Hume, 128 U.S. 195, 211 (1888), “debtors must be just before they are generous.” Under section 548(a)(1)(B) of the Bankruptcy Code, a transfer is deemed constructively fraudulent where the insolvent debtor makes a payment (or any other transfer of an interest in property) for which the transferee does not provide “reasonably equivalent value” while the debtor is insolvent. Constructively fraudulent transfers are avoidable and recoverable for the benefit of the bankruptcy estate irrespective of whether, and to what extent, the initial transferee received the payments in good faith. Simply put, absent a showing of “value” provided in exchange for the transfers, it does not matter whether the college or university had knowledge of the parent’s insolvency or fraud or otherwise received the tuition payments in good faith.
It is important to note that the Bankruptcy Code (and comparable state law fraudulent transfer statutes) provide for avoidance of both actual and constructive fraud-based transfers and transactions. Under the actual fraud theory of recovery, the trustee may avoid transfers intended to frustrate current or future creditors’ recovery efforts. Section 548(a)(1)(A) of the Bankruptcy Code provides, in pertinent part—
(a)(1)The trustee may avoid any transfer (including any transfer to or for the benefit of an insider under an employment contract) of an interest of the debtor in property, or any obligation (including any obligation to or for the benefit of an insider under an employment contract) incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily—
(A) made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted . . . .
The trustee has the burden of establishing intent.[8] To the extent the intent at issue in a case is to defraud, courts are split on whether the standard of proof is by a preponderance of evidence or by clear and convincing evidence.[9]
In the context of avoidance actions brought against colleges and universities to recover tuition payments, the decisional authority most often turns on analysis of constructive fraud claims. In Palladino, for example, the trustee asserted both actual fraud[10] and constructive fraud claims. However, the First Circuit’s Palladino opinion was based primarily on its finding that the debtor parents received no value in exchange for the payments they made for their daughter’s education. There the court reasoned:
The tuition payments here depleted the estate and furnished nothing of direct value to the creditors who are the central concern of the code provisions at issue. The code recognizes five classes of transactions that confer value: (1) the exchange of property; (2) the satisfaction of a present debt; (3) the satisfaction of an antecedent debt; (4) the securing or collateralizing of a present debt; and (5) the granting of security for the purpose of securing an antecedent debt. 11 U.S.C. § 548(d)(2)(A). None are present here, nor are parents under any legal obligation to pay for college tuition for their adult children.
The First Circuit noted that such payments by an insolvent debtor, irrespective of the noble cause, will be undone by bankruptcy rules allowing trustees to claw back transfers. The First Circuit declined to recognize an exception not enacted by Congress via statute. The bankruptcy court, from which the appeal was taken, had found the Palladinos paid their daughter's tuition because "they believed that a financially self-sufficient daughter offered them an economic benefit" and as such determined value had been provided.[11] Rejecting this analysis, the First Circuit urged that “value” be considered from the perspective of the creditor, for whose benefit fraudulent transfer laws were established, not the debtor parents.
3. DEFENSES
In defending against claw-back actions, colleges and universities should consider and hold the trustee to her burden of establishing each element of the claim. A trustee may challenge a transaction as constructively fraudulent by establishing:
- A transfer or incurred obligation;[12]
- Of an interest of the debtor;
- For less than reasonably equivalent value; and the debtor
- was insolvent or became insolvent as a result;
- was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;
- intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured; or
- made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.[13]
Upending any one of the required elements will defeat a fraudulent transfer claim.
Further, at least one court has ruled that the university would be deemed a mere conduit where funds are first deposited into a student controlled account, albeit managed by the institution; the funds are not withdrawn or otherwise under the dominion of the institution until the student enrolls in courses at the institution, and such funds are refundable if the student withdraws from the institution.[14] In Hamadi, the court determined that the university was shielded from liability under section 550(b)(1) of the Bankruptcy Code, which prohibits trustees from “recovering from an immediate transferee of an initial transferee who ‘takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided[.]’” A key factor in the court’s ruling in favor of the university was that it was deemed an immediate (or subsequent) transferee rather than the initial transferee of the tuition payments. To be clear, the statutory defense is only available to good-faith subsequent transferees.[15] Like the payment structure in Pergament, the shielded University of Connecticut tuition payments came from a student-controlled account funded by the parents and were refundable to the student up until he registered for courses.[16]
4. EXTRAJUDICIAL EFFORTS TO PROTECT EDUCATIONAL INSTITUTIONS
Although the age of majority in most states is 18, society expects and legally presumes that parents will contribute to the higher education costs for children 18 and over. Indeed, as colleges and universities know all too well, a student’s eligibility for need-based financial aid is based on the institution’s “Cost of Attendance” less the “Expected Family Contribution.”[17] The Expected Family Contribution is determined by a federally mandated calculation based on information submitted in the student’s Free Application for Federal Student Aid. As noted by one commentator, “it seems counterintuitive to limit a student’s financial aid award because it is decided his parents can afford to contribute a certain amount to his education and then later call these transfers fraudulent if the parents file for bankruptcy.”[18] Courts have acknowledged this conundrum in ruling on trustee tuition claw-back actions. In In re Oberdick, 490 B.R. at 711–12, the court rejected a trustee’s fraudulent transfer claim after noting the parents testimony that (1) they viewed the college tuition and related educational expenses for their adult children as family obligations, and (2) they were denied state and federal student aid for the adult children because of the “expected family contribution.”
Federal legislators have also recognized the disconnect between federal higher education policy and federal bankruptcy law. In 2015, the Protecting All College Tuition (PACT) Act was introduced by Representative Chris Collins of New York. would be shielded from recovery.[19] The PACT Act of 2015 did not advance out of committee.
5. CONCLUSION
Although Palladino is the first appellate decision to address claw back of tuition payments, it is likely not the last. Unless and until Congress enacts legislation to shield tuition payments from avoidance, colleges, universities, and their counsel must be prepared to defend against fraudulent transfer actions. The strategic offense principle as crystalized in the adage “the best defense is a good offense” comes to mind. As detailed above, some institutions have lodged successful defenses by establishing administrative protocols that distance them (somewhat) from funds received from students’ parents. Others will no doubt be well served to monitor developments in the law and employ a broad-based strategic offense.
[1] Monique D. Hayes is a partner in the law firm Goldstein & McClintock LLLP. She is co-chair of the ABA Business Law Section Young Lawyer Committee and a member of the ABA Business Law Section Business Bankruptcy Committee, serving as co-chair of the Executory Contracts Subcommittee and a member of the Current Developments Task Force.
[2] In 2014, Debtors Steven and Lori Palladino pled guilty to investment fraud in connection with a Ponzi scheme they orchestrated using their family business, Viking Financial Group. Like many Ponzi schemes, the Palladino’s fraud ensnared friends and business associates as well as vulnerable elderly investors. The Palladinos petitioned for chapter 7 bankruptcy relief prior to pleading guilty to the fraud charges. A trustee was appointed to oversee their bankruptcy proceedings. During the bankruptcy case, the trustee uncovered nearly $65,000 in transfers the Palladinos made to Sacred Heart University, Inc. as tuition payments for their legally adult daughter. The bankruptcy trustee sued the university to avoid and recover the tuition payments as fraudulent transfers.
[3] See In re Sterman, 594 B.R. 229 (Bankr. S.D.N.Y. 2018) (finding debtor’s tuition payments on behalf of nondebtor are avoidable and recoverable by a bankruptcy trustee); In re Knight, 2017 WL 4410455 (Bankr. D. Conn. Sept. 29, 2017) (same); Matter of Dunston, 566 B.R. 624 (Bankr. S.D. Ga. 2017) (same); In re Leonard, 454 B.R. 444 (Bankr. E.D. Mich. 2011) (same); In re Lindsay, 2010 WL 1780065 (Bankr. S.D.N.Y. May 4, 2010) (same). Compare In re Adamo, 582 B.R. 267 (Bankr. E.D.N.Y. 2018) (subsequent history omitted); In re Palladino, 556 B.R. 10 (Bankr. D. Mass. 2016); Shearer v. Oberdick (In re Oberdick), 490 B.R. 687 (Bankr. W.D. Pa. 2013); In re Cohen, 2012 WL 5360956 (Bankr. W.D. Pa. Oct. 31, 2012), rev’d in part on other grounds, 487 B.R. 615 (W.D. Pa. 2013); In re Lewis, 2017 WL 1344622 (Bankr. E.D. Pa. Apr. 7, 2017) (declining to allow avoidance and recovery of tuition payments).
[4] A key concept to grasp is the meaning of the term “avoid” as used in the bankruptcy context. It describes the ability of a trustee to set aside, invalidate, nullify, disregard, or unravel a transfer, transaction, or obligation of a debtor in bankruptcy. As detailed herein, the powers afforded under chapter 5 of the Bankruptcy Code allow the trustee to avoid certain liens, set-aside fraudulent transfers (whether granted through actual or constructive fraud), and claw back.
[5] Most states have enacted a version of the Uniform Voidable Transactions Act (formerly the Uniform Fraudulent Transfers Act) approved by the National Conference of Commissioners on Uniform State Laws. To clarify, most states enacted the predecessor statute, the Uniform Fraudulent Transfers Act. The revised and renamed version has been enacted by some, but not a majority of, states.
[6] Consider, by way of example, the Florida Uniform Fraudulent Transfer Act. See Fla. Stat. 726.101 et seq. Specifically, section 726.105 of the Florida statutes provides, in pertinent part, as follows:
(1) A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor's claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation:
- With actual intent to hinder, delay, or defraud any creditor of the debtor; or
- Without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor:
1. Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or
2. Intended to incur, or believed or reasonably should have believed that he or she would incur, debts beyond his or her ability to pay as they became due.
[7] In the case of Mukamal v. Citibank (In re Kipnis), 555 B.R. 877 (Bankr. S.D. Fla. 2016), the bankruptcy court permitted a trustee to reach back 10 years to unwind a fraudulent transfer by grafting the IRS 10-year statute of limitations.
[8] See Jacobs v. Jacobowitz (In re Jacobs), 394 B.R. 646, 661 (Bankr. E.D.N.Y. 2008); MFS/Sun Lift TrustHigh Yield Series v. Van Dusen Airport Servs. Co., 910 F. Supp. 913, 934 (S.D.N.Y. 1995); Glinka v. Bank of Vt. (In re Kelton Motors, Inc.), 130 B.R. 170, 179 (Bankr. D. Vt. 1991).
[9] The decisional split on the standard of proof is beyond the scope of this article but should be noted in examining actual fraud-based avoidance actions. For more on the issue, see Baldi v. Lynch (In re McCook Metals, L.L.C), 319 B.R. 570 (Bankr. N.D. Ill. 2005). Practitioners and thought leaders have tried to reconcile the issue by establishing pleading standards, revising state statutes and commentary, and limiting to use of the term “fraud” as it relates to avoidance actions. See Uniform Voidable Transfers Act, § 4(a), off. cmt. 10.
[10] In cases where the debtor operated a Ponzi scheme, as did the Palladinos, courts have found actual intent to defraud is presumed to the extent the transfers at issue furthered the Ponzi scheme. See, e.g., Gredd v. Bear, Stearns Secs. Corp. (In re Manhattan Inv. Fund, Ltd.), 359 B.R. 510, 517–18 (Bankr. S.D.N.Y. 2007), aff’d in part, rev’d in part, 397 B.R. 1, 22–26 (S.D.N.Y. 2007).
[11] DeGiacomo v. Sacred Heart Univ., Inc. (In re Palladino), 556 B.R. 10, 16 (Bankr. D. Mass. 2016).
[12] Although this article focuses primarily on cash tuition payments as potential fraudulent transfer targets, it is important to note that the applicable statutes allow challenges to debt obligations (i.e., loans, guarantees, etc.) as well. To the extent colleges and universities accept such obligations from parents, they should be prepared to defend the propriety of the transaction in the event of the parents’ insolvency.
[13] See 11 U.S.C. § 548(a)(1)(B); see also UVTA § 4(1)(b).
[14] Pergament v. Hofstra Univ. (In re Adamo), 582 B.R. 267 (Bankr. E.D.N.Y. 2018), vacated and rem’d on other grounds sub nom., Pergament v. Brooklyn Law Sch., 595 B.R. 6 (E.D.N.Y. 2019); see also Mangan v. University of Conn. (In re Hamadi), 597 B.R. 67 (Bankr. D. Conn. Jan. 31, 2019).
[15] See 11 U.S.C. § 550(b)(1).
[16] In re Hamadi, 597 B.R. at 70.
[17] See How Aid Is Calculated?, Federal Student Aid (last visited Dec. 27, 2019).
[18] Jenna C. MacDonald, Out of Reach: Protecting Parental Contributions to Higher Education from Clawback in Bankruptcy, 34-1 Emory Bankr. Dev. J. 264 (2017).